Chapter 3

Judgmental and Ethical Decision-

Making Frameworks and

Associated Professional Standards

Copyright © 2010 South-Western/Cengage Learning

Rittenberg

Johnstone

Gramling

AuditingA Business Risk Approach

7e

Audit Opinion Formulation Process

LO 1 Framework for Professional Decision-Making

LO 2 Accepting a Public Trust

• To maintain the public's trust, public accountants must act with professional integrity

• Ethical problem occurs when an individual is morally or ethically required to take an action that may conflict with his or her immediate self-interest

• Ethical dilemma occurs when there are conflicting moral duties or obligations

LO 5 The Sarbanes-Oxley Act of 2002 as a Reaction to Ethical Lapses

International Ethics Standards Board for Accountants

The IESBA Code of Ethics require accountants to adhere to five fundamental principles:

• Integrity

• Objectivity

• Professional Competence and Due Care

• Confidentiality

• Professional Behavior

The AICPA Principles of Professional Conduct (continued)

• Responsibilities - members should exercise sensitive professional and moral judgment in all their activities

• Public interest - members should act in a way that serves the public interest, maintains public trust, and shows commitment to professionalism

• Objectivity and independence - members should be objective and free of conflicts when performing professional responsibilities. Members in public practice must be independent in fact and appearance when providing attestation services.

The AICPA Principles of Professional Conduct (continued)

• Integrity - members should perform all professional responsibilities with the highest sense of integrity

• Due care - members shall observe the profession's ethical and technical standards, strive to improve competence and quality of services provided, and discharge professional responsibilities to the best of their ability.

• Scope and nature of services - members in public practice shall observe the principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.

The AICPA Rules of Conduct

Rule 101: Independence

Rule 102: Integrity and Objectivity

Rule 201: General Standards

Rule 202: Compliance with Standards

Rule 203: Accounting Principles

Rule 301: Confidential Client Information

Rule 302: Contingent Fees

Rule 501: Acts Discreditable

Rule 502: Advertising and Other Forms of Solicitation

Rule 503: Commissions and Referral Fees

Rule 505: Form of Organization and Name

Independence – Rule 101

Rule 101: "A member in public practice shall be independent in the performance of professionalServices as required by standards promulgated bybodies designated by the Council."

• The auditor is required to be independent when providing attestation services. The standards for providing consulting, tax, or bookkeeping services do not require independence.

• There are several interpretations that provide more detailed guidance on the application of Rule 101.

Independence – Rule 101

• Independence would be considered impaired if during the period of engagement, a covered member had, or was committed to acquire, a direct or material indirect financial interest in an attestation client

• Covered member is defined as– An individual on the attest engagement team– An individual in a position to influence the attest

engagement, or– A partner in the office in which the lead attest engagement

partner primarily practices in connection with the attest engagement

Independence – Rule 101

• A covered member's immediate family is also subject to Rule 101 with some exceptions

• Independence would be considered impaired if a member holds key positions with attest clients during the period covered by the financial statements or the period of engagement

• A covered member's independence would be considered impaired if a close relative is employed and has a key position with the client or has a material financial interest in the client of which CPA has knowledge

Integrity and Objectivity - Rule 102

• Requires members to act with integrity and objectivity, be free of conflicts of interest, and not knowingly misrepresent facts or subordinate their judgment to others.

• Rule applies to performance of all professional services by all members

General Standards - Rule 201

• Members shall provide only those services that they are able to perform with professional competence

• Members shall exercise due professional care in performance of services

• Professional services shall be adequately planned and supervised

• Members must gather sufficient relevant data to provide a reasonable basis for any conclusions or recommendations rendered in connection with professional services

• Applies to all services provided by all members

Confidential Client Information - Rule 301

• In order for an auditor to develop a complete understanding of the client, there must be a free flow and sharing of information between client and auditor. To ensure this happens, the client must be assured that the auditor will not communicate confidential information to outside parties.

• Rule 301 prohibits members from disclosing confidential client information obtained during an engagement except with client consent.

Confidential Client Information - Rule 301 - Exceptions

• Disclosures required by GAAP or GAAS• Comply with subpoenas or summons or to comply

with applicable laws and government regulations• Provide information for outside review of firm's

practice under PCAOB, AICPA, or State Board of Accountancy authorization

• Initiate a compliant with, or respond to inquiries made by, recognized investigative and disciplinary agencies (including the AICPA, state CPA societies, State Board of Accountancy)

Contingent Fees - Rule 302

• Contingent fee - fee for the performance of a service where the collection or amount depends on whether a specified finding or result is attained

• Contingent fees are prohibited for any service provided to an attestation client. Why? Such contingent fees would give the auditor a financial interest in client results

Commissions and Referral Fees - Rule 503

• Members in public practice are prohibited from receiving commissions for recommending products and services to attest clients. Why? The commission gives the auditor a financial interest in his/her client's decisions.

• Commissions are allowed for recommending products or services to non-attest clients, but must be disclosed to the client

• Members may pay or receive fees for referral of any professional services (including attest services) as long as the client is notified of the fee

Enforcement of the Code

• Members who violate the AICPA code may have their membership terminated

• Members who violate a State Board of Accountancy's code are subject to disciplinary action including suspension or revocation of the member's certificate and license to practice.

• If the State Board suspends the member's certificate, it can mandate conditions, such as additional continuing education, that must be satisfied before the member's certificate is reinstated.

LO 7 Independence Rules of the SEC and the PCAOB

• SEC and PCAOB have established independence guidance and rules that apply to auditors of publicly held companies

• The SEC has taken a principles-based approach in dealing with independence issues

Independence Rules of the SEC and the PCAOB

• Auditor independence is impaired when– mutual or conflicting interest between the

accountant and the audit client is created– accountant is placed in the position of auditing his

or her own work– accountant is acting as management or an

employee of the audit client– An accountant is placed as an advocate for the

audit client

Prohibited non audit services

• Bookkeeping or other services related to the accounting records of audit client

• Financial information systems design and implementation

• Appraisal and valuation services, fairness opinions, or contribution-in-kind reports

• Actuarial services,• Internal audit outsourcing services,• Management functions, etc

LO 8 Further Considerations Regarding Auditor Independence

• Independence is the cornerstone of auditing profession

• Auditors must be independent – in fact – objective and unbiased in their actions

and– in appearance – perceived by knowledgeable users

of financial statements as independent

LO 9 Major Threats to Independence

• Compensation schemes

• Who is the client?

• Familiarity with the client

• Time pressures

• Rationalizing behavior

• Providing nonaudit services

Managing Threats to Independence

• Establishing and monitoring corporate codes of conduct

• Developing appropriate compensation schemes• Implementing high-level reviews of decisions to

accept or retain clients• Separating consulting activities from audit activities• Performing within-firm reviews of audit work and

audit documentation• Performing reviews and inspections within the

profession

Important Role of Audit Committees

• Oversight of engagement of company’s external auditor

• Overseeing auditors independence

• Preapprove permitted services provided by auditor

• Require firms to communicate certain information related to the firm’s independence